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...and should
the bear awake
by Charles Corvallis
The long bull market may well
have simply suffered a couple of burps and continue
to charge on. On the other hand, spring is just
around the corner and there are signs that the
bears are stretching in their lairs. They may
well be hungry after the long hibernation that
began in October 2002.
To protect yourself from being
mauled — however unlikely it is that you'll
come across one in your particular piece of forest
— it can't hurt to take a broad look at a
few industries that may perform better than others
in a soft economy.
Pharmaceuticals: The
industry continues to consolidate through mergers
and acquisitions. Should there be a downturn these
may slow but the underlying value of companies
is unlikely to be affected. Though regulatory
pressures on how products are marketed will continue
to grow both here and in the US, the demand for
pharmaceuticals is expected to increase as the
population ages. Research in biologicals, vaccines
and pharmacogenomics continues apace and is certain
to produce marketable new products over the medium
to long term. Another bonus: Pharmaceutical firms
are relatively inflation proof in the unlikely
event that it occurs.
Medical devices: From
stents to joint replacement to artificial organs,
medical devices are destined to play an increasingly
important role in medicine. The industry should
not be much affected by a downturn. Two companies
to watch: Allergan with its devices to aid in
weight loss and Kyphon, a California company that
has had strong success with a device that relieves
pressure on the spine. There are many others.
Other industries that
can be expected to outperform the market in a
slowing economy: eco-based businesses; established
e-firms; coffee retailers such as Starbucks, Second
Cup. Distasteful as it is, companies that pedal
vice do well when others stumble: cigarettes,
whisky and gambling all look like good bets.
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A period of unusual calm drew to
a close on February 27. That day the Chinese market
dropped 9%, closely followed by sagging stock markets
around the world; the TSX fell 2.7%; the Dow was off
3.3%. The sharp decline ended the second longest period
in 50 years without a 2% correction and in which single
day volatility had almost disappeared. If any confirmation
was needed that volatility was back, investors received
it on March 14 when markets were shaken. They quickly
regained their composure.
The sharp break in the market seemed
particularly brutal following such an extended period
of calm. The correction likely reflects a long-overdue
adjustment of risk premiums within capital markets —
not a sudden negative turn for economic expectations.
Well-executed monetary policy both here and in the US
delivered an economic soft landing throughout the summer
and early fall of last year. Reacceleration in the fourth
quarter of 2006 initially suggested an upside risk to
growth, but more recent data indicates moderation. Indications
are the economy continues to follow closely along the
'path' laid by central bank planners.
I believe that going forward, stable
rates point to stable growth at a moderate pace. The
Chicago Fed National Activity Index (CFNAI), a weighted
average of 85 monthly indicators, is now at a level
consistent with sustainable growth coupled with low
inflation. Further, surveys indicate that expectations
of higher inflation have declined again, confirming
the wisdom of monetary policy. Past soft landings have
led to a period of economic expansion of anywhere from
18 months to more than six years. With stable growth
and moderating inflation, the onset of the next recession
may have been pushed out past this decade's end! We
can only hope.
The massive stimulus given to the
economy over the decade's first half has ended. Central
banks now appear to be pursuing a neutral policy. Should
market volatility continue, the Bank of Canada and the
US Federal Reserve are less likely to launch any pre-emptive
strikes on inflation by raising interest rates. That
is even less likely given the fourth quarter surge we
witnessed in 2006, along with the fact that inflation
expectations are cooling.
Furthermore the bull market in
small caps — gene-rally companies with less than
$ 1.5 billion in capitalization — has pushed the
Index above its equilibrium channel while much more
modest gains for large caps have left the Standard &
Poors (S&P) 500 just below fair value (and most
of our portfolios are large cap in nature). Small caps
typically lead the market through periods of surging
profit growth, but year-over-year gains for S&P
500 earnings have slowed to 4.0% from double-digit levels
of 2003, 2004, 2005 and 2006.
When all is said and done, the
correction in equity markets and the return of market
volatility likely signals a healthy reassessment of
risk premiums, not a negative swing in the economic
outlook or a fatal blow to the bull market.
Here are four promising things
to keep in mind when considering your portfolio:
- Economy is growing at
a moderate pace.
- Inflation, and more importantly
inflation expectations, are moderating.
- Hikes in short term interest
rates are unlikely.
- Large cap stocks as a
group appear to be priced below fair market value.
Charles Lasnier is an Investment
Advisor with RBC Dominion Securities Inc. [email protected].
This article is for information
purposes only. Please consult with a professional advisor
before taking any action based on information it contains.
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PHYSICIAN LIFE
